8.15.2011

To stabilize the economy and combat the 1970 inflation rate of 5.84%, on August 15, 1971, President Nixon imposed a 90-day wage and price freeze, a 10 percent import surcharge, and, most importantly, "closed the gold window", ending convertibility between US dollars and gold. The President and fifteen advisers made that decision without consulting the members of the international monetary system, so the international community informally named it the Nixon shock. Given the importance of the announcement — and its impact upon foreign currencies — presidential advisers recalled that they spent more time deciding when to publicly announce the controversial plan than they spent creating the plan

Exactly 40 years ago Monday, the U.S. dollar formally became a fiat currency, as then-President Richard Nixon “closed the gold window” and ended the greenback’s precious-metal guarantee.

And though a market price for the dollar was soon accepted as the new normal, the debate over a return to the gold standard has now resurfaced in a way we haven’t seen in the four decades since.

Many practical hurdles to a gold dollar exist — most significantly the tremendous difficulty in defending a metal-backed currency, even if the new gold standard opened with a major devaluation for the U.S. unit.

On 15 August 1971, with the US public finances straitened by the cost of the war in Vietnam, Richard Nixon finally cut the link between the US dollar and gold. Until then, the US Treasury was duty bound to exchange an ounce of gold with central banks willing to pay them $35.

Suddenly, for the first time in history, the level of the world's currencies depended not on the value of gold or some other tangible commodity but on the amount of trust investors had in that currency. Central banks were allowed to set monetary policy based on their instincts rather than on the need to keep their currency in line with gold.

It was one of those seminal moments whose significance has only gradually become apparent, obscured as it was at the time by Vietnam and then Watergate. But the more one examines economic history, the more obvious it is that this was one of the most important policy decisions in modern history.

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Let's start with first principles: for as long as anyone can remember, politicians have sought to spend more than they can afford. Since the invention of money they have discovered ever more ingenious ways to do so.

The initial method involved debasing the currency. Henry VIII earned his nickname "Old Coppernose" because he added so much copper to what were supposed to be silver coins that eventually it would show through on the nose of his portrait.

These bouts of debasement typically end in disaster, as faith is lost in the currency, inflation shoots through the roof and the economy collapses, after which politicians introduce a new, more credible system.

After trust evaporated in gold and silver coinage, we had the gold standard and then the Bretton Woods system and now, today, fiat money – but the routine is painfully familiar. The main difference with fiat money is that whereas under the gold standard it was all too obvious when politicians were spending beyond their means (they would simply run out of gold reserves), these days it is slightly more difficult to tell quite how close the system is to breakage.

Nonetheless, as we look back at the chaos of the past few weeks, it is quite clear that our current version is on its last legs. This, in essence, was the point Sir Mervyn King tried to make again and again in the Inflation Report press conference last week: 2008 was only one stage in a far bigger crisis of confidence in the way we have structured the world economy.

Over the past 40 years, in the absence of a coherent international monetary system and under the veil of floating currencies, countries which would otherwise have been penalised for doing so were allowed to borrow enormous amounts (eg. The US and UK, or Greece). Other countries (eg. China or Germany) indulged them by lending enormous amounts. In the meantime, investors convinced themselves that the apparent economic growth fuelled by this debt was genuine rather than an artificial product of a binge.

The 2008 crisis represented the first recognition that those increases in asset prices and economic growth were chimerical. The recent relapse represents a recognition that the losses have merely been transferred on to sovereigns' balance sheets.

But what next? The Panglossian answer is that those imbalances are slowly but surely put right: indebted countries borrow less and repay their creditors. But countries rarely go gently: what seems more likely is that the next stage of the crisis represents a crisis of confidence in the very system which, founded as it is on trust rather than measurable yardsticks, has no reliable, inbuilt way of righting itself.

So are we nearing the end of this economic era? All the hallmarks are there. We've been through the periods of faith in the system, peaking with the certain belief in the 1990s and early 2000s that inflation targets really would help keep governments on an even keel.

We've had the financial crisis that usually marks the beginning of the end of established monetary systems. And now we are seeing the debasement.

Consider the price of gold, which has recently scaled new highs. Since the 1970s the price per ounce has risen from below $40 to an astonishing $1740. The price reflects many factors, including economic growth, but chief among them is a diminishing faith in the ability of fiat currencies to maintain their value.

Ignore the oil price shock and the mild fluctuations over time: it is no coincidence that the price really started to spike (in other words faith in currencies versus gold plunged) in 2001, which just so happens to be the year central banks first started experimenting with quantitative easing (QE) – in Japan.

1 comment:

JP, you sound as if you possibly might be a proponent of real money instead of a fiat currency which historically has destroyed just about every economy in which it's implemented. I was just over at Christian website and I am constantly amazed at the gullibility and naivety of conservative Christians. About the only true conservative in the race, Paul, is denigrated with insane comments such as "he's for pot smoking." Paul is the only one who has the honesty to actually address monetary policy seriously. And these same people criticize him for actually questioning whether going in and invading any and all countries of the world is always the right choice. As if it's such a bad thing to not intervene militarily all over the world wherever we want to impose our will.